Writing on economics, ethics and philosophy

Vale, Volcker

By George P. Brockway, originally published June 1, 1987

A COUPLE OF years ago, Mayor Edward I. Koch was asked who was responsible for pulling New York City back from the brink of bankruptcy. In one of his formerly frequent bright moments, he replied. “Well, I suppose someone has to get the credit, and it might as well be me.”

But they don’t deserve all the credit. They should share it with Paul A. Volcker, for they couldn’t have raised the interest rate to usurious heights without his help. That may not be a nice thing to say about a man who is now retiring from government after many years of undoubtedly self-sacrificing service. Unhappily; I have some even less nice things to say. I say them not only in sorrow but also in anger, because people have been hurt-have had their lives ruined-by the lordly mistakes of this big man, and because his smaller successor as chairman of the Federal Reserve Board, Alan Greenspan, is apparently ready to keep making most of the same mistakes (besides, when the wind is north-northwest, declaring his devotion to Ayn Rand and longing for the gold standard).

Let’s briefly examine the Volcker record in five areas- (1) inflation, (2) general welfare, (3) economic output, (4) foreign trade, and (5) the deficit and then look more closely at his underlying theory. Volcker is admittedly not single-handedly responsible for the bad things-or the good things, if any-that can be pointed to in each case. He had a lot of help from Ronald Reagan, from legions of people who were sure they were doing what the President would have wanted had he been paying attention, and -yes- from you and me. Nevertheless, even if Paul VoIcker wasn’t, as the commentators liked to say, the second most powerful man in the world, he is, as they also say, a legend in his own time. It’s really what he stands for that I will [be] talking about.

1. Inflation. There is no doubt that VoIcker’s present fame is based on his claim to have been the tamer of the inflation dragon. He took office at the Fed in October 1979 and immediately began his attack. What really happened? From that December through December 1986, the Consumer Price Index (CPI) rose 51.06 per cent in constant dollars. In comparison, the increase from 1972 through 1979 was considerably greater, 73.50 per cent, but from 1964 through 1972 it was considerably less, 34.88 per cent. And if we go back to the bad old days of Harry S. Truman, we find that the increase from 1948 (following the jump when wartime controls were suddenly ended) through 1952 was only 10.26 per cent. On the record, VoIcker, the great inflation tamer, turns out not to have been all that great.

2. General Welfare. VoIcker never made a secret of the fact that his program was going to hurt. That may have been, as Ring Lardner would have said, one of its charms. Again using constant dollars, we find that from 1964 through 1972 the median family income increased 25.46 per cent; from 1972 through 1979 it increased 1.56 per cent; but in the VoIcker years, from 1979 through 1985 (the latest Economic Report of the Presidentdoesn’t have 1986 figures for this), the median income fell 4.56 per cent. Given that more families had multiple wage earners in 1985 than earlier, the drop in family income was even steeper.

The fate of the poor was much more dramatic. The number of our fellow Americans living in poverty actually declined 32.13 per cent from 1964 through 1972; it held unchanged from 1972 through 1979; but it jumped 26.81 per cent in the Volcker years.

On October 19, 1979, shortly after taking office, Volcker proclaimed, “The standard of living of the average American has to decline.” He made it happen.

3. Economic Output. Volcker’s rationale for hurting people was that inflation would thus be controlled, and the rationale for controlling inflation was that prosperity depended on it. As we have seen, inflation was only slightly restrained; perhaps it will be said that is why the recovery has been so lackluster.

The GNP rose (in constant dollars) 32.19 per cent from 1960 through 1972; 22.38 percent from 1972 through 1979; and only 12.30 per cent in the Volcker years. Since the working-age population increased 8.19 per cent in the last period, and more people produce and consume more goods, the Volcker recovery has been overpraised.

4. Foreign Trade. Everyone knows that our recent performance in foreign trade has been abysmal. If the monthly deficit on current accounts falls a point or two, it is hailed as a triumph. Everyone knows, too, that the strong dollar of recent years has made it difficult for American industry to compete either at home or abroad. What few remember, however, is that the strong dollar was a deliberate objective of Volcker’s policy, announced as early as October 17, 1979. It was supposed to stabilize international trade, and it sure made it fun to travel in Europe and to buy Volvos and Mazdas and madras shirts in the U.S. All this naturally contributed to the trade deficit and put Americans out of work. It also made it easier to sell American bonds-not goods but bonds-abroad. Volcker wanted the strong dollar because it made it easier to finance the American deficit-again a way to achieve a questionable result by imposing unquestionable hardship on millions of people.

5. The Deficit. The deficit question is a phony, and so is the problem of financing it; and I don’t mean merely that it wouldn’t have seemed important if it hadn’t been for the Kemp- Roth tax cuts. Volcker certainly isn’t to blame for those. He is to blame, though, for crying wolf over the deficit.

There are a few ways a national debt is like a personal debt, and one of them is that the amount of debt a nation can bear is a function of its income. Poor people and poor countries have trouble with small debts; rich people and rich countries can carry big debts. The United States’ debt is always thought enormous by knee-jerk conservatives; this was one of Reagan’s arguments against Jimmy Carter. In 1979 the Federal debt held by the public (some of it, of course, is held by government agencies, mainly Social Security) was 26.33 per cent of GNP. That was one of the lowest ratios in years, but Reagan promised to wipe it out and Volcker strengthened the dollar to help him. By 1986 the debt had risen to 41.94 per cent of GNP. This is a lot hairier than the 1979 animal, but even so it’s not a real wolf.

For something like a real wolf, we can go back to 1946, the last year of World War II, when the Federal debt held by the public was 113.62 per cent of GNP. If there is validity to the notion that a high debt/GNP ratio induces or requires a high interest rate, the 1946 rate should have been wild. Yet in that year, three-month Treasury bills paid all of three-eighths of 1 per cent, and the prime was 1.5 per cent.

Now consider this: During the Volcker years the Federal debt held by the public increased by $1,102 billion, and the interest paid on that debt amounted to $844 billion. Suppose the 1946 rate had been paid instead of the Volcker rate. The interest bill would have been reduced by about $812 billion, while the debt itself would have increased only $290 billion. At the same time, the debt/GNP ratio would have fallen to 2.46 per cent-hardly anything to get excited about (except as probably too low), and certainly below the urgent need for foreigners to invest in our bonds.

It comes down to this: Volcker allowed interest rates to soar, partly to reduce the average American’s standard of living, and partly to encourage foreign investment in government bonds. He was successful on both counts. But if the rates had been lower, the deficit would have been minuscule, and the foreign investors wouldn’t have been needed. High interest rates simply gave a lot of money to rich foreigners-and to rich Americans, too.

I HAVE ALREADY said that Volcker’s attack on the inflation dragon was not outstanding. I now make the heretical claim that his maneuvers with the interest rates indeed caused inflation to be greater than it might have been.

First, let me make a minor observation. The inflation rate is not a figure you read off an instrument, like barometric pressure. It is a statistical construction, and one of its factors is the interest rate. Consequently, interest rates and inflation rates have a tendency to go up and down together. This is an arbitrary and possibly small effect, and one that could be eliminated by slight pressure on a computer key; nonetheless, it stands as a real fact in the real world.

Second, let me make the much more important observation that speculation is vastly stimulated by volatile interest rates. Volcker says that if the strong dollar weren’t available to bring in foreign money, Federal borrowing would crowd producers out of the money market. But speculation can always crowd out production, and that is what Volcker’s policy has encouraged.

There is a still more serious effect than either of these. If you are running a business and your friendly banker says he wants 20 per cent to renew your 10 per cent loan, your first defense is to increase your prices. Moreover, the loan isn’t the only thing that bothers you, because what economists call the “opportunity cost” of the money you and others have invested in your business increases as well. That is, whoever invests in your business passes up the opportunity to make easy money by being a lender rather than a borrower; so you have to raise prices to take care of that, too, and keep your colleagues from wanting to sell out.

A significant aspect of these increases is that they are percentages. What’s more, similar percentage increases are being made by everyone who supplies you with raw materials or rents you office space or provides shipping services for you. Every company below you in the production chain is adding a percentage to its prices, and you add your percentage on top of their inflated prices, and the companies above you in the chain do the same. The result is that, as Adam Smith observed in a little-noticed passage, prices are increased geometrically, whereas a wage increases pushes up prices only arithmetically.

The immediate impact of an increase in interest rates, therefore, is an increase in inflation. Of course, the intended decrease in the level of business follows sooner or later (it took Volcker almost three years to get things down to where he wanted them). Sooner or later, people can’t afford the new prices. Businesses can’t sell as much as they used to. Workers get laid off. Unions get afraid to strike. Wages are held down, and so price increases can be relaxed. This is what Volcker frankly worked for. But true to Adam Smith, we see that when wages go down (empirically, when any cost-including interest-goes down), prices fall only arithmetically; and if interest rates remain high, the net pressure on prices will continue to be upward.

Even a very severe depression (and Volcker made us one) will at best slow inflation; it will not stop it as long as interest rates remain high.

Volcker’s announced policy was to control the money supply (Ml) and let the interest rate take care of itself.

His theory was that a controlled money supply would raise the interest rate, and that a drop in the inflation rate would take place. He was never able to keep M1 growth within the guidelines advocated by Milton Friedman. It’s just as well.

As the table above shows, in 1981 a minor fall in Ml growth (one of only two such occurrences in Volcker’s career) was accompanied, not by a rise, but by the second largest fall in the prime rate, and followed by the largest fall in the CPI. On the other hand, in 1985 the biggest jump in Ml was accompanied by a substantial fall in the prime and followed by the most dramatic fall in the CPI. In general, the figures in the table can be made to support Volcker’s theory only by appeals to “lags” and “anticipations” and other statistical gyrations of the sort J .B. Rhine used to “prove” extrasensory perception. For true believers in the Volcker magic, when 1980’s slight tightening of the money supply was followed by a slightly lower inflation rate, that “proved” the theory. But when 1984’s greater tightening was followed by an increased inflation rate, that “proved” businessmen had expected the tightening and had moved to offset it. Either way, Volcker’s theory was a winner. But such pseudo-logic can equally “prove” the opposite.

In short, there is no way on earth to construct a valid correlation of changes in the money supply, interest rates and inflation rates that will support Volcker’s theory of what he was doing. And there is no way on earth to deny that what he did reduced the standard of living of average Americans and forced millions more into poverty. The theory that I (and Adam Smith) have advanced (for a somewhat fuller exposition, see my note in the Winter 1986-87 Journal of Post Keynesian Economics) goes at least part way in showing why Volcker’s theory was wrong.

A case can be made for many Volcker virtues, especially in impeding somewhat the rush to deregulate banking. But the false legend of big Paul Volcker and the dragon is one that shouldn’t be told to children-or to grown-ups, either.